Some stocks offer big promises, little (or no) profits

When we run across a mailing or online post hyping a little-known stock as the next great investment, it can be hard to resist. But that’s very often the right thing to do.

Most of the stocks that are breathlessly promoted are risky penny stocks (that is, priced below about $5 per share). Here are some red flags to watch out for:

Lots of capital letters and exclamation marks, along with appeals to your emotions. If you’re being told about “an Oil-Stock Gusher” or that a company has a deal in the works that “points to HUGE Profits for early shareholders,” be wary.

Strangely specific claims, such as that an expected deal “will soon drive the stock above $20!” or that you can expect a newsletter’s future recommendations to rise more than 30 percent in fewer than 30 days. At such a rate of return, a single $1,000 investment would grow to more than $6.8 billion in just five years.

An unprofessional company website. If you look up the company’s website, and it features poor grammar and misspellings and pages “under construction” or absent, that’s a bad sign. You should find clear, honest communication from the company and be able to find audited financial statements for it, too.

If you’re tempted to buy, ask yourself this: If these tiny companies really are such compelling bargains, why would they need to advertise? Wouldn’t knowledgeable folks already have discovered them? And if there were demand for the shares, wouldn’t their prices have risen, rather than fallen to “bargain” levels?

A seemingly inexpensive share price doesn’t mean a stock is a good value. A 50-cent stock can soon become a 5-cent one (and often does), while a $100 stock can double to $200 and keep growing.

Answer: It’s when you invest with money borrowed from your brokerage, paying interest for the privilege. Using margin will amplify your gains — but also your losses.

Here’s an extreme example: Imagine that you hold $100,000 of stocks and you borrow $100,000 on margin to invest in additional stock. If your $200,000 portfolio doubles in value to $400,000, you’ll have earned an extra $100,000 (less interest expense) thanks to margin.

But if your holdings drop by 50 percent, they’ll be worth $100,000 and you’ll still owe $100,000 (plus interest). That will leave you with ... nothing. Your holdings dropped by 50 percent, but margin amplified that to a total, 100 percent loss. Margin cuts both ways.

Consider the interest expense, too.

If you’re borrowing on margin and paying 9 percent interest, you should be pretty confident your borrowed stocks will appreciate more than 9 percent. If they fall below a certain level, you’ll receive a “margin call.” If you can’t add the required additional dollars, the brokerage will sell some of your holdings to generate the cash, possibly resulting in short-term capital gains taxed at high rates.

Only experienced investors should use margin, and many have done well without ever using it.

My dumbest investment

Didn’t sell Apple: My worst investment decision was not selling Apple at $700 per share. I believed the hype that it would hit $1,000. I did manage to escape by $550. I realized a very good return on my initial investment, but greed got in the way of a great return.

The Fool responds: You submitted this regret some months ago, when Apple shares were trading in the low $400s. They’ve recently been in the low $500s, reminding us of the value of patience.

Try not to evaluate your investments by looking backward, at how much they’ve grown or shrunk. Instead, try to assess whether they’re overvalued or undervalued considering how well you expect the company to perform going forward.

If you thought, for example, that Apple would keep introducing innovative products and charging premium prices for them, you might have opted to ride out downturns, expecting shares to recover and keep growing — to $1,000 and beyond. If you thought Apple’s growth phase was over or even if you were just very uncertain, maybe selling was smart, no matter the stock price.

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